Written by

Ian Stewart

Published

October 24, 2013

Things certainly have changed for the United Kingdom in the last six months. Financial markets now believe that a gathering recovery will force the Bank of England to raise interest rates in 2014, far earlier than had been expected at the start of this year. The previously moribund UK housing market has strengthened so much that there is growing talk of a housing bubble (see figure 1). It is a sign of the times that in late September the Financial Times ran an editorial entitled, “Osborne wins the debate on austerity,” which argued that a run of strong economic data had vindicated the UK chancellor’s deficit reduction program and confounded his Keynsian critics.

After years of downside shocks, the UK outlook is looking brighter. UK GDP rose by 0.7 percent in the second release, the fastest rate in more than three years and with activity fairly broadly based (see figure 2). GDP forecasts for 2014 have nudged higher since March. The nearly universal assumption is that growth in the industrialized world will bounce back in 2014 led by accelerating activity in the United Kingdom, the euro area, and North America.

The mood in the United Kingdom has been boosted by a perceived reduction in risks in the global economy. The world financial system seems to be on a gradually improving path. Fears that the Eurozone would break up have eased, and reform in the periphery of the euro area is delivering improvements in competitiveness. The US recovery is eroding America’s vast budget deficit. In the United Kingdom, financial markets are worrying less about economic weakness and more about the risk of early interest rate rises.

In early August, the new governor of the bank of England, Mark Carney, sought to counter an involuntary tightening of UK monetary policy caused by Ben Bernanke’s “tapering” speech in May. Mr Carney announced that UK interest rates would stay at their current level of just 0.5 percent until unemployment falls below 7.0 percent. With the jobless rate at 7.6 percent, and the Bank not expecting it to fall below 7.0 percent until late 2016, the message to consumers and business was that low interest rates are here to stay for three more years.

Markets are not convinced, even after the US Fed’s rate-setting committee rowed back from an early slowing of bond purchases at their September meeting. UK base rates stand at 0.5 percent, and the day after the Fed announcement, on September 20, financial markets were betting on UK rates rising to the 0.75 percent mark by late 2014 to 1.5 percent by the end of 2015 and to 2.25 percent by the end of 2016.

Cheap money and the absence of big external shocks are working their magic. In the last few months, survey indicators of activity and confidence have picked up across the United Kingdom. The composite purchasing managers index, covering services, manufacturing, and construction, has risen to its highest level since 1997. The third quarter Deloitte CFO Survey shows a sharp drop in perceptions of macro uncertainty, and risk appetite has risen to an all-time high (see figure 3). Optimism about the outlook for growth in the United Kingdom, the rest of Europe, and the United States rose sharply, and longstanding optimism about emerging markets dimmed somewhat. Our index of corporate defensiveness—based on the weight CFOs place on cost cutting, building up cash, and deleveraging—has dropped sharply. It is clear that the defensive balance sheet strategies that marked the recession are in the back seat.

This is unlikely to be the perfectly balanced recovery so fervently hoped for by UK policymakers. Some of the hallmarks of previous lopsided recoveries are already starting to emerge: lower consumer savings, rising credit growth, and higher house prices. The reality is that the control that policymakers exercise over the economy is very limited and imperfect. As a result, policymakers will doubtless take the view that while balanced growth is better than unbalanced growth, either is far better than no growth.

Some of the hallmarks of previous lopsided recoveries are already starting to emerge: lower consumer savings, rising credit growth, and higher house prices.